By Tanvi Kanchan
With markets being volatile, what are the kinds of risk your portfolio is exposed to. Between late March 2020 and middle of October 2021, equity markets across the world experienced significant bull run. While this rally started with extremely attractive equity valuation, significantly better than expected corporate earnings fed the rally and increased asset allocation into equities sustained the rally. By the late phase of this rally, the market witnessed some froth and that started the correction.
Subsequently, the geopolitical and economic situation changed drastically and quickly. In particular, significantly higher than anticipated inflation and aggressive monetary tightening to control the situation, the Russia Ukraine war and zero Covid policy led lockdown in China rattled investor confidence. High global commodity prices and actual and anticipated destruction of demand impacted equity market outlook. All these factors are behind the ongoing correction in the global equity markets.
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At the current level, a significant part of the actual and anticipated deterioration in macro environment and corporate earnings are already factored in. That said, the near term economic and corporate earnings outlook is not particularly encouraging. Consequently, some further corrections in the equity market cannot be ruled out. Moreover, both during the bull and the beer phases, the equity market generally overreacts.
Every asset class has a varying level and degree of risk it carries and reacts differently during volatile period. Basis the investment objective, we tend to try to get a balance between our targeted return and the risk that is associated with it. For any portfolio, the appropriate level of risk must first be determined and then needs to be calculated to make sure it lies within the defined or acceptable limits. Risk can be classified in 4 major categories.
Stock Market or Equity risk: It is the risk caused due to the volatile nature of the market, where the prices of stocks keep fluctuating due to various reasons. A few examples are a natural disaster, pandemics, inflation, recession, political unrest, fluctuation of interest rates, and so on. Market risk is also known as systematic risk. One thing that helps is the time period that the investors stay invested in. for instance, a one year rolling return calculated for a period from 1995 to 2021 shows the maximum return at 92% and the minimum at -53%, taking the same duration, if we calculate a 5 year rolling return the minimum is -5% and the maximum is 44%, now again at a 10 year rolling return, the minimum stands at 4% and the maximum at 20%. This, very clearly proves that while short term volatility persists, but it reduces enormously over a longer period of time.
Credit Risk: This risk is faced by all Debt Fund investors where the borrower defaults or delays in payment cycle.
Interest Rate Risk: This change in bond prices is primarily driven by the interest rates in the economy. Interest rates and bond prices share an inverse relationship. So, when the interest rates in the economy increase, the prices of existing bonds decrease since they continue to offer the old interest rates. This interest rate risk varies for bonds with different maturities. Those with longer maturity would witness higher price fluctuations in comparison to those with shorter maturities. This is because longer duration bonds have to make more coupon or interest payments than a bond with a short maturity.
Inflation Risk: Inflation is the rise in the general level of prices of various goods and services that we consume. It erodes the purchasing power of money.
It is the combined risk of each individual investment within a portfolio. The different components of a portfolio and their weightings contribute to the extent to which the portfolio is exposed to various risks.
While investing in risk free asset classes might feel like you are avoiding risk, the underlying risk of inflation is always prevalent, so you end up taking a bigger risk of capital erosion. Investing in risk free assets could end up destroying about 75% of your wealth over a period of 30 years.
To generate returns in excess of Inflation, we have to take some Risk. While risk is unavoidable, it is manageable and the key to good portfolio management is in managing Risk. A good diversified long term oriented portfolio, in line with your risk taking capabilities is the key to creating good long term wealth.
A good investment plan should consist of an allocation plan where your assets are well diversified in equities and debt. The debt part of your portfolio helps to provide cushion during volatility and consistent returns while the equity part generates alpha over your benchmark.
(Tanvi Kanchan, Head – Corporate Strategy, Anand Rathi Shares and Stock Brokers. Views expressed are the author’s own.)